Reinvestment Rate Assumption
The preceding discussions have revealed that in the case of mutually exclusive projects, the NPV and IRR methods would rank projects differently where (a) the projects have different cash outlays initially, (b) the pattern of cash inflows is different, and (c) the service lives of the projects are unequal. It has also been found that the ranking given by the NPV method in such cases is theoretically more correct. The conflict between these two method is mainly due to different assumptions with regard to the reinvestment rate on funds released from the proposal. The assumption underlying the IRR method seems to be incorrect and deficient. The IRR criterion implicitly assumes that the cash flow generated by the projects will he reinvested at the internal rate of return that is same as the proposal itself offers. With the NPV method the assumption is that the funds can be a equal to the cost of capital, that is. the required rate of return. The crucial is which assumption is correct? The assumption of the NPV method is considered to be superior the virtue of having a rate which cannot be applied to all investment proportional the rate of return represents an rate of investment. In to the NPV method, the IRR method assumes a high reinvestment rate. for investment proposals having a high IRR and a low investment rate for investment proposals having a low IRR. The rate with differ depending upon the cash flow stream for each investment proposal. Obviously under the IRR method; there can be as many rates of reinvestment as there are investment proposals to evaluated unless some investment proposals turn out to have an IRR which is equal to that of some other projects.
The superficiality of the reinvestment rate under the IRR method can be demonstrated by comparing the following two investment projects.